Sunday, 8 March 2009

My last entry ended with a comment on how entrepreneurs in emerging markets need to be part Hernando de Soto, the Peruvian economist, and part Steve Jobs. In case the reference to de Soto was missed, I wanted to clarify why I mentioned him and explain why I feel so strongly about this point.

When doing business in an emerging market it is of the utmost importance to try and understand why it is a developing economy. Let’s be realistic, there are economic reasons behind why emerging markets are labeled as “emerging” and not as members of the OECD. Too often businesses and investors overlook these critical economic factors resulting in increasing timelines and spiraling costs.

I used Hernando de Soto as an example because his institute, the Institute for Liberty and Democracy, is dedicated to “opening up” emerging markets. The ILD looks for hidden patterns of social interaction within the barriers of the existing legal framework to see how the legal framework influences the sizes of the formal and informal economies. Or more simply, does the country's legal system cause people to work illegally and if so, which parts and why? Anyone wishing to do business in Nigeria, or any emerging market for that matter, should also study these patterns. Understanding how taxes and laws affect business behaviour is incredibly important. This knowledge will allow entrepreneurs and investors to determine if a business model will be succesful and what new opportunities will open up if a government starts a regulatory reform plan.

For example, from my time in the Balkans, I experienced the practice of misrepresenting asset values in order to create desired share capital. In many civil law economies share capital must be justified against actual assets and approved by a court appointed evaluator. Normally when a business is established the share capital represents the initial investment or the cash available and determining the share capital value is not complicated. But if the company is transitioning from a limited company to a joint share company, the existing fixed assets must be “valued” in order to justify the issued share capital. In these situations the court evaluator is bribed to ‘value’ the company’s assets at the desired amount of share capital. This archaic practice causes odd evaluations of company assets to be carried on the books year to year. I once took over a company that had gone through this situation - old equipment that was rusting in the courtyard was worth thousands of euro on the books. Before I figured out the story behind the asset values, I was repeatedly refused overdraft loans when I tried to use the assets as collateral. The better banks knew the book values of the equipment could not be trusted. If I had understood this common yet technically ‘corrupt’ practice before I took over, I would not have wasted time applying for loans using a court document stating the value of the company’s assets as a lien. Instead I would have focused on correcting the books first and foremost.

Anyone who has worked in or is from an emerging market knows of similar black & grey business operations. However, most people don’t understand why these some of these practices differ between economies and where they come from. Anyone doing business in an emerging market needs to understand that the root cause of the informal economy and black & grey practices is generally a poor and unfavourable regulatory environment. For example, a break through paper by Robin Burgess and Timothy Besley, titled: Can Labour Regulation Hinder Economic Perfromance? Evidence from India, made the connection between increased labour regulation and the informal economy, stating that the size of the former drives the size of the latter.

From a more general perspective, those doing business in Nigeria and other emerging markets should recognize that the root cause behind black & grey practices are generally driven by three generic business regulation scenarios:

Poorly designed and outdated laws - for example the prominence of notaries in civil law systems probably helped stop forgeries 100 years ago, but today it is just an extra blockade causing gridlock in the business environment. In these environments otherwise honest brokers commit fraud just to get their day-to-day business complete. In Puerto Rico the most common reason for suspension of a law license is notary forgery.

The “grabbing hand” theory - laws remain in place because they are lucrative to public officials who are able to take advantage of the power afforded to them - bribing officials to get a license or to push through documentation faster. These systems stay in place because they allow governments to keep civil service salaries low knowing the employees will earn the difference by collecting bribes. Do not expect to see reform in this area unless the involved government is combining an awareness campaign with higher civil service salaries.

Good on paper, bad in practice (the enforcement/execution problem) – these scenarios are commonly found in countries like Nigeria where the federal system cannot be enforced evenly throughout the country. The legal system may present a favorable business environment in theory but the legal institutions do not have the capacity to execute causing local customs to take over. For example, the failure of state legal systems in the northern Nigerian states has prompted many states to take up Sharia law.

Before doing business in Nigeria, it is important to understand how Nigeria’s legal system will influence the behavior of your customers, suppliers, competitors, and employees. In some respect, doing business in Nigeria has its advantages compared to other emerging markets thanks to common law and the flexibility of an interpretive legal system. But Nigeria suffers from outdated legal practices left over from both colonial and military rule (especially in the area of property law) and from the good on paper, bad in practice problem. In many states tribal legal traditions take precedent over the official legal system, especially when it comes to dispute resolution. Where and how the official legal system of Nigeria is actually practiced is not an easy answer and before doing business in Nigeria you should understand which laws affect your business, how they vary by state and how they influence day-to-day business practices.

But no matter how studied you are on Nigerian law, finding a good lawyer is still a must. An honest lawyer, with local knowledge and experience, can help you avoid potential potholes when setting up your business and help you structure the business so as to avoid operating in potential black or grey areas. I highly advocate everyone, even locals that feel they have their fingers on the pulse of the business environment, to not get involved in business in Nigeria without a good, local lawyer.

To find a Nigerian lawyer you don’t always need a local recommendation when you can access Oloja.com. There are 600 legitimate Nigerian lawyers listed on Oloja.com, just search for “Solicitor/Lawyer”.

Abraham Kamarck

P.S. I'd be very interested to hear about anyone else's experiences with grey business practices in emerging markets, especially Nigeria.

P.P.S. As I help Femi and Dapo set-up their new Nigerian e-businesses, I've become very interested in Nigerian Intellectual Property Law, as I research it more it will likely be the subject of my next blog.